GERMANY - The regulatory environment for the establishment and operation of an Islamic bank in Germany

The regulatory environment for the establishment and operation of an Islamic bank in Germany
September 2011

• Introduction
• Overview of the financial supervisory law in Germany
• No special rights for Islamic finance
• Commencement of business
• Organisation of business operations
• Rules of conduct to be complied with in business operations; securities regulatory law
• Tax
• View all pages

Source : Norton Rose Website

Introduction

In October 2009, Jochen Sanio, President of the Federal Finance Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht - BaFin), stated that there are no general regulatory obstacles for establishing and licensing an Islamic bank in Germany. Mr Sanio even promised to smooth the regulatory way for Islamic finance in Germany.

What has to be recognised, however, is that although these statements have been repeated since then, even in 2011 a fully licensed Islamic bank is still not in existence in Germany.

This memorandum gives a description of the regulatory environment, which would be of relevance for the operation of an Islamic bank in Germany. It should be noted, however, that many of the described aspects are based on opinions of the authors and that a clear administrative practice of BaFin does not yet exist.

Banks can be called Islamic, if they conduct their business exclusively in accordance with the Islamic system of values and norms of the Shariah (and in particular, the rules and principles specified in Muamalat). This means that they use certain techniques in their business transactions which are approved by Shariah law. These types and/or techniques include, among others:

• Mudaraba (a joint-venture-based type of financing technique, which is also used for structuring Islamic accounts),
• Musharaka (a partnership-based type of financing technique, which in the form of a diminishing Musharaka also allows for the gradual diminishing of one partner).
• Quard Hassan (an asset management technique),
• Ijara (a leasing technique) and
• Murabaha (a trade credit technique).

Overview of the financial supervisory law in Germany

Anyone wishing to conduct banking business or to provide financial services (collectively referred to as Finance Transactions) on a commercial basis in Germany, is required by principle to obtain a licence from BaFin in accordance with Section 32 sub-section 1 of the German Banking Act (Kreditwesengesetz - KWG). The same applies to companies having their residence in a foreign country and conducting Finance Transactions through a branch office in Germany or through their office in a foreign country on a cross-border basis, unless the respective company has its place of residence in another EEA member state and has obtained a licence from the supervisory authority in that country.

The licence must be obtained before commencement of business; entries in the official registers (e.g. commercial registers or registers of co-operative societies) are only permissible after the registration court has been provided with evidence that the licence has been granted.  The licence may be granted with reservations and/or limited to specific types of banking business. Conducting banking business without licence constitutes a criminal offence.  If Finance Transactions are conducted without having the required licence, BaFin may order the immediate discontinuation of business operations and the immediate settlement of these transactions.
Not only the commencement of Finance Transactions, but also the organisation of the business operations and the conduct of the Finance Transactions are supervised by BaFin.  This applies in particular to the trading, and the offer of financial instruments which are subject to the German Securities Trading Act (Wertpapierhandelsgesetz - WpHG).

No special rights for Islamic finance

In Germany, no special supervisory regime has been established for Islamic finance activities. Whether or not these activities are subject to regulatory supervision depends on whether or not they qualify as Finance Transactions.
The KWG specifies the types of business that qualify as Finance Transactions subject to regulatory supervision (aufsichtspflichtige Finanzgeschäfte), including:

• deposit business;
• lending business;
• principal broking services;
• investment brokerage and investment advice, portfolio management; and
• financial leases.

Any Islamic finance product must be examined in the actual form in which it is offered in order to identify whether it constitutes a Finance Transaction and is subject to regulatory supervision. While transactions in the form of Mudaraba, Diminishing Musharaka and Quard Hassan will generally be considered as Finance Transactions, Musharaka, Ijara and Murabaha are not considered as such. It is to be stated, however, that the mere offer of one single type of transaction that is subject to supervision is sufficient for the entire business of the offeror to become subject to regulatory supervision.
The types of Islamic finance transactions that shall be offered are also decisive for determining whether a full banking licence is required or whether a partial banking licence or a licence for providing financial services is sufficient. The latter may usually be obtained more easily. If deposit and lending business shall be conducted – which, for example, is usually the case with Mudaraba and Quard Hassan transactions – a full banking licence will be required in any case.

Commencement of business

According to the KWG, the granting of a licence to conduct Finance Transactions is subject to a number of requirements, the most significant of which are:

Sufficient capital

The amount of capital that is required varies according to the business that is conducted. The capital of deposit-taking credit institutions must at least amount to €5 million, while for securities trading banks €730,000 are, in general, sufficient.

Qualified and reliable managers

The institution must have two professionally qualified and reliable managers. The managers must have a clean criminal record and have sufficient management experience. Although it is generally desirable that the management experience was gained in Germany, it is also imaginable in case of Islamic finance transactions that BaFin takes into account that there is no German practice in this area so far.
In addition thereto, it must be ensured that all important business decisions are taken by the managers. In this context, the Shariah Board is significant: While under German law it is permissible that a Shariah Board in the context of Islamic finance transactions takes an advisory position, the relevant business decisions must still be taken by the managers.

Reliability of shareholders

Besides the managers, also the owners, representatives or general partners of a company, who exert substantial influence on the institution, (which is generally presumed in case of an interest of at least 10 per cent) have to be reliable. This means that also foreign shareholders of an Islamic bank operating in Germany have to provide evidence as to their reliability to BaFin in appropriate form.

The licence application which shall be accompanied by a number of documents, is to be submitted to BaFin. Of particular importance are a business plan, which contains details regarding the nature of the planned business and a substantiated indication of its future development (projected balance sheets and projected profit and loss accounts) for the first three full business years following the commencement of business operations, a presentation of the organisational structure of the institution and a presentation of the planned internal control procedures.

Organisation of business operations

Pursuant to the KWG, the organisation of a bank’s business operations has to comply with certain requirements. These include in particular:

Own funds and liquidity

Banks must have adequate own funds in order to meet their obligations to their creditors, and, in particular, safeguard the assets entrusted to them. Moreover, banks have to invest their assets in a way as to always maintain sufficient liquidity to meet all payment obligations at any time.
Both in risk weighting and with respect to liquidity assessment, the particularities of Islamic finance products have to be taken into account. In this respect, there is still a lack of experience and need for further development in regulatory practice.

Risk management

Banks must have a proper business organisation, which ensures that the legal provisions to be adhered to by the institutions and the operational needs are complied with. A proper business organisation must, in particular, comprise an appropriate and effective risk management, on the basis of which an institution has to ensure its risk-bearing ability on an ongoing basis.
In the case of Islamic banks, some aspects which are of lesser importance for conventional financing transactions, will become important, such as the purchase agreements in Murabaha transactions.

Membership in a deposit guarantee scheme (EAEG)

German banks are obliged to protect their deposits (and liabilities arising from securities transactions) by joining a compensation scheme (Section 2 of the Act on the Protection of Deposits and Investor Compensation (Einlagensicherungs- und Anlegerentschädigungsgesetz – EAEG)). This obligation could conflict with the obligation to bear losses under a Mudaraba. One way to avoid this conflict could be a model already applied in Great Britain under which the bank is required to offer to its customers the protection provided by a deposit guarantee scheme while giving them the possibility not to use such system.

Prevention of money laundering, terrorist financing and fraud

The Money Laundering Prevention Act (Geldwäschebekämpfungsgesetz – GwG) which implements the Money Laundering Directive 91/308/EEC of 10 June 1991, as amended, imposes extensive identification and reporting duties on banks, financial institutions, insurance companies and German branches of foreign credit institutions or financial services institutions. BaFin supervises the compliance with duties arising out of the GwG.

Rules of conduct to be complied with in business operations; securities regulatory law

When conducting their business, banks have to observe comprehensive duties and requirements, such as, for example, the rules of conduct and transparency that apply in connection with the distribution of financial instruments (Sections 31 et seq. WpHG). Customers, in particular, have to be fully informed of all risks associated with the products. These duties apply to Islamic banks, for example, when distributing Sukuk. Due to the fact that such products are still largely unknown in the German market, information standards still need to be developed.

Tax

Some Islamic financing techniques, such as Ijara or Murabaha, comprise a transfer of title to property or comparable rights. In Germany, a sale and transfer of title is usually subject to tax – i.e., in general, value-added tax, or, in case of real property, real property acquisition tax. Taxation may lead to a substantial increase of costs of Islamic finance transactions, due to which they may become rather unattractive, compared to conventional financing. However, there are possibilities to reduce the tax load. One example is the Sukuk Ijara of the German state of Saxony-Anhalt issued in 2003, within the scope of which the underlying real property was not transferred, but a head-lease-sublease structure was chosen.